Securitization: More Than Just a Regulatory Artifact

Competitive and regulatory pressures have prompted banks and other financial intermediaries to participate in credit markets in ways that are not directly reflected on their balance sheets. This poses a problem for regulators, who must assess the risks of these off-balance-sheet lending activities. One such activity is the packaging of loans into marketable securities, which is known as asset-backed lending or securitization.

For example, banks and other loan originators often sell fixed-rate mortgages to government-sponsored agencies, which in turn package these loans with those acquired from other institutions into mortgage pools. The agency sells securities that are claims to these pools to investors in the bond market. In the past several years, securitization has spread beyond government-sponsored activity to private asset-backed pools that fund a wide range of loans.

The recent proliferation of asset-backed lending has raised questions about its impact on the performance of banks. This concern reflects the fact that banks are involved in many aspects of the securitization process, such as packaging, servicing, or enhancing the credit worthiness of these securities. Regulators must determine what risks securitization poses to the participating institutions and how these risks should be reflected in the assessment of bank capital requirements.

This Economic Commentary explores banks' incentives to engage in securitization. Part of the dramatic increase in this activity can be traced to banking regulations that raise the cost of funding loans with deposits. However, another important factor driving asset-backed lending by banks is the improvement in information technology that has made securitization cost effective. Indeed, the proliferation of asset-backed lending to nonbank firms indicates that this mode of funding has become efficient for firms not subject to these regulatory costs.

From this perspective, we contend that securitization itself is not undesirable, and in fact is an efficient response by banks to their changing financial environment. Securitization serves as a vehicle for institutions to mitigate both credit and interest-rate risks, while generating fee income for participating banks. Moreover, the securitization process enables banks to attract investors who would otherwise not hold bank liabilities. Nevertheless, securitization poses a challenge to regulators, as they must assess how this activity affects risk in the banking industry.

* SECURITIZATION AND DIVERSIFICATION

As their name suggests, depository institutions, such as commercial banks and savings and loans (thrifts), have traditionally funded their lending activities by attracting deposits. However, until 1986, deposit-rate ceilings limited the ability of these institutions to attract funds when market rates rose above regulated maximums. Banks and thrifts also tended to operate in fairly localized markets because of information costs and regulations limiting the scale and scope of banking activities. Depositories were therefore vulnerable to local credit-market conditions, such as the health of the local real-estate market. This was particularly true of thrifts, which were required to hold a certain fraction of their portfolios as residential mortgages.

Indeed, asset-backed lending began as an outgrowth of the government's effort to increase the flow of funds to the mortgage market. In the late 1960s, government-sponsored credit agencies such as the Federal National Mortgage Association (Fannie Mae) and the Government National Mortgage Association (Ginnie Mae) were established to create a secondary market in which existing mortgages could be sold. These agencies operated as intermediaries, buying government-guaranteed mortgages and funding these acquisitions by issuing securities. In 1970, Ginnie Mae issued a new type of credit-market instrument: the mortgage "pass through," which was a claim to the return on a specified pool of mortgages. …

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